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Tax Evasion through Trade Intermediation:
Evidence from Chinese Exporters
Xuepeng Liu†
Kennesaw State University
Huimin Shi††
Renmin University of China
Michael Ferrantinoξ
The World Bank
December 20, 2014
Abstract
Many production firms use intermediary trading firms to export indirectly. This paper
investigates the tax evasion motive through indirect trade, using Chinese export data at
transaction level. We provide strong evidence that, under the partial export VAT rebate
policy of China, production firms can effectively evade value-added taxes (VAT) by
under-reporting their selling prices to domestic intermediary trading firms, especially when
they sell differentiated products. The benefit of such an evasion can be as high as 17% of the
under-reported value. This tax evasion motive is estimated to have an economically
comparable and often larger effect on trade intermediation compared to factors examined in
other studies for Chinese exporters. Even for a moderate level of under-reporting, the revenue
loss is close to one billion U.S. dollars. We also find that such under-reporting behavior
through domestic intermediaries may be associated with cross-border evasion through
under-reporting export values to foreign partners. In addition, our result indicates that the
evasion motive is stronger for larger transactions.
Acknowledgement: We thank Carlos Ramirez, Mark Rider and the participants at the International and
Development Economics Workshop at the Federal Reserve Atlanta，the North America Chinese Economists
Society Meetings at Purdue University，and China Meeting of Econometric Society at Xiamen University for
comments and suggestions.
† Xuepeng Liu, Associate Professor of Economics, Department of Economics & Finance, Coles College of
Business, Kennesaw State University (email: xliu6@kennesaw.edu). †† Huimin Shi (corresponding author),
Assistant Professor of Economics, School of Economics, Renmin University of China (email:
huiminshi@ruc.edu.cn). ξ Michael Ferrantino, Lead Economist, International Trade Department, the World
Bank (email: mferrantino@worldbank.org). Disclaimer: The findings, interpretations, and conclusions
expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the
International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of
the Executive Directors of the World Bank or the governments they represent.
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1. Introduction
Production firms can export directly by themselves or rely on intermediary trading
firms to export for them (indirect exports).1 Intermediary trading firms play an important role
in international trade. In the U.S., wholesale and retail firms account for about 11 percent and
24 percent of exports and imports respectively (Bernard et al., 2010). In the early 1980s, three
hundred Japanese trading firms (sogo shosha) handled 80 percent of Japanese trade (Rossman
1984). According to the data from China Customs, indirect exports in China accounted for 38
percent of the shipments and 21 percent of the value in the year of 2005. Despite the
extensive studies at firm level in the recent trade literature, the role of trading firms has not
been fully explored. This paper investigates the tax evasion motive behind indirect exports in
China, stemming from the partial export value-added tax (VAT) rebate policy.
In countries that adopt a destination-based VAT, including China, the VAT should be
collected on domestic transactions, but not on exports. The VAT on the value added at the
final stage before exporting should be exempted, and the previously paid input VAT should
be fully refunded in principle so that exporters can regain their initial competitiveness. Unlike
the full rebate policy in the EU and elsewhere, China has a partial rebate system with rebate
rates less than or at most equal to collection rates. The unrebated part of the VAT becomes
effectively an export tax,2 which is calculated based on the export prices for direct exporters
(production firms) but domestic purchasing prices for indirect exporters (trading firms).
To evade such an export tax, exporters have an incentive to under-report either their
export prices or domestic purchasing prices. 3 Direct exporters (production firms) may
directly evade the effective VAT by under-reporting its FOB price as long as they can find
foreign partners to collude in order to recover the loss due to under-reporting. Indirect
exporters (trading firms) may have an incentive to under-report their domestic purchasing
price to evade VAT; they also have an incentive to under-report export prices to minimize
purchasing-selling price differentials, which is used by the government to detect tax evasion.
Although foreign partners are also needed to recover the under-reported values, trading firms
1 Our focus is on the case where a production firm sells its products to an intermediary trading firm, with the
trading firm taking charge of the tax rebate. Alternately, the intermediary’s main role may be to help a
production firm to find buyers, while the production firm is still in charge of the tax rebate itself. We analyze the
former case because we do not observe the latter case directly.
2 Feldstein and Krugman (1990) show that a destination-based VAT system should provide exporters full
rebates and an incomplete rebate is equivalent to an export tax.
3 Ferrantino, Liu and Wang (2012) provide empirical evidence for how production firms may have incentive to
under-report their export values in the case of direct exports, while the current paper investigates the evasion
through indirect exporting. The evasion behaviors discussed in these papers are different from another popular
type of VAT evasion by firms within a VAT-adopting country in which they over-report their input VAT using
fake invoices to obtain more input VAT credits and hence reduce their VAT liabilities.
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are more skilled to do so because they are normally larger, more politically connected, and
more familiar with foreign markets than production firms. As a result, it is relatively easier
for trading companies to under-report prices than production firms. This paper explores how
firms evade such an export tax through indirect exports.
The above discussion suggests a positive correlation between export tax rates (i.e., the
nonrefundable part of VAT) and probability of indirect exporting, which is measured by the
share of indirect exports in our product level analysis. That is, the higher the implicit export
tax, the more likely it is that exporting will be done through an intermediary. We test this
hypothesis using China Customs export data at the transaction level for the year 2005, which
is the first year after the full liberalization of trading rights under China’s WTO
commitments.4 This correlation is empirically robust, especially for differentiated products
whose values are easier to under-report than homogenous products, and is also stronger for
the exports of state-owned enterprises (SOEs), which are more politically connected with the
government than private or foreign firms.
As mentioned above, although the VAT rebate to a trading firm is not based on its
final export price, it may also have an incentive to under-report exporting prices to minimize
the chance of being caught. This is because the purchasing and selling price differential is
used by Chinese tax authorities to detect evasion behaviors. Such a view is supported by a
product-country level analysis. This implies that the tax evasion through domestic trading
firms may be associated with cross border evasion in the case of indirect exports. Therefore,
both types of evasion should be reflected in the under-reported export values and the data
reporting discrepancies between China and importing countries. The current paper provides a
complete explanation for the export price under-reporting by both direct and indirect
exporters, which in turn helps to explain why China reported exports are significantly smaller
than the corresponding imports reported by partner countries such as the U.S. The
fast-growing trade of China, especially its exports and large trade surplus, has drawn
increasing attention. Investigating the incentives behind the under-reporting of China’s
exports not only provide policy makers a clearer picture of China’s trade but also help
authorities to detect and curb evasion behaviors.
Although the scope of VAT evasion is usually considered to be small because this tax
4 We choose to use the data for year 2005 for the following reasons. First, before 2005, the export and import
right was under the examination and approval system. Production firms would have to choose indirect exports if
they did not have export right, which is unrelated to tax evasion. Second, two other related papers on Chinese
intermediary firms, Ahn, Khandelwal, and Wei (2011) and Tang and Zhang (2012), also use the data of 2005.
To facilitate the comparison with their work, we follow them
